1. INVENTORY CAS 500 – Audit evidence
CAS 501 – Audit evidence – Specific considerations for selected items
CAS 505 – External confirmations
CAS 520 Analytical procedures
CAS 620 – Using the work of an Auditor’s expert

2. The Complexity of Inventory
Why?
A major item
Inventory items could
Very diverse items are included
Valuation needs to consider
One client may use several methods

3. Functions in the Inventory and Warehousing Cycle
Process purchase orders
Receive new materials
Store materials
Process goods
Store finished goods
Ship finished goods

4. An Overview of Functions, Documents, and Accounting Systems
Starting point
E.g. Stockroom
Purchase details
Purchase Requisition N
Prepare prenumbered Purchase Requisition
Accounts Payable
Purchasing

5. Determine Vendor, Prepare prenumbered Purchase Order
Purchasing Department
Purchase Requisition
Determine Vendor, Prepare prenumbered Purchase Order
Purchase Order N
Originating Department
Accounts Payable
Vendor
Receiving

6. Receive New Materials
Receiving Report
Blind copy of Purchase Order
Count goods, match with Purchase Order, and prepare Receiving Report A
Accounts Payable
Purchasing
Originating Department with goods
Filed until goods received along with invoice copy

7. Compare. Then prepare Voucher and enter in Voucher Register
Vendors Invoice
Purchase Requisition
Purchase Order
Receiving Report
Vendor’s Invoice
Voucher
Compare. Then prepare Voucher and enter in Voucher Register D
Purchasing
Originating Department
Receiving
Vendor
Voucher Register to General Accounting
To Cash Disbursements when due

8. Storage Raw Materials Cost Accounting Requisition Raw Materials
Goods are placed in storage. Raw materials perpetual inventory updated
Goods from Receiving
Inventory Master file N
Goods are placed in production
Cost Accounting
Production
Raw Materials
Requisition

9. Manufacturing Raw Materials Requisition Storage N
Goods are placed in storage in production
Finished Goods to storage
Goods
Cost Accounting Records

10. Finished Goods Storage
Update Perpetual Inventory Master File. Update Cost Accounting Records
Finished Goods to shipment
Finished Goods from Production
Finished Goods Master File
Cost Accounting Records

11. Finished Goods Shipment
Order Entry
Approved Sales Order
Sales Order
Bill of Lading
Bill of Lading
Billing and A/R
Bill of Lading
Prepare Multi-Part Bill of Lading. Update Perpetual Inventory Master File on shipment
Bill of Lading
Customer
Common Carrier
Finished Goods Master File

12. The Audit of Inventory Price and compile inventory
Acquisition and Payments, Payroll and Personnel
Inventory and warehousing
Sales and Collections
Audit area
Cycle
Acquire and record raw materials, labour, and overhead
Internally transfer assets and costs
Ship goods and record revenue and costs
Physically observe inventory

13. Cost Accounting Typical Controls Physical controls
Good controls are essential
Physical controls
Inventory must be protected from theft and misuse
What does the auditor look for?
If auditor assesses the physical controls and inadequate?

14. Documents and Records If testing internal controls
Auditor examines
Testing a series of documents
Does the auditor always test the controls around inventory production?

15. Inventory files
When does the auditor examine the Perpetual Inventory system?
If level of control risk is low
This can be assessed by

16. Analytical Procedures
Compare gross margin percentage with previous years
Compare inventory turnover with previous years
Compare unit costs of inventory with previous years
Compare extended inventory value with previous years
Compare current-year manufacturing costs with previous year

17. Designing Tests of Controls for the Acquisition and Payment Cycle
Must consider IR for Inventory.
Materiality for Inventory is allocated from planning materiality. Probably want a low audit risk for Inventory as it is usually very material. E.g. 5%
Set materiality.
Assess Audit Risk and Inherent Risk for Inventory and Warehousing
Use last years assessed CR for Payments and Sales and Collections If not available, estimate based on initial system review and discussions with client. Will eventually use the assessed materiality after testing.
Assess Control Risk for the applicable cycles
e.g. obsolete or slow moving inventory. I f not identified, could be a risk of material misstatement
Identify assertions where substantive testing is insufficient, and/or there is risk of material misstatement
e.g. Perpetual inventory – can attend counts throughout the year
e.g. Sample size will be affected by reliance on internal controls
e.g. Monetary unit sampling could be used to select the actual items
e.g. Low CR, could do substantive testing early
Design test for those controls on which the auditor will rely. You cannot assess CR without testing
Design and perform test of control for the applicable cycles. Assess control risk
Tests of details can be reduced if CR is low. Analytical procedures are performed as additional persuasive evidence.
Amount of testing is indirectly related to DR
The type of audit procedure?
What is the sample size?
Items to be selected?
Timing – when to do the procedure?
Design and perform substantive tests of inventory.

18. Physical Inventory Observation: Existence
Remember McKesson & Robbins 1937
Select a random sample of tag numbers
If inventory is not tagged
Movement of inventory

19. Auditor’s Observation of Inventory
First task is to review client’s inventory-taking instructions.
Auditor will also perform test counts.

20. Items of Special Note Physical inventory not on year-end date:
Cycle inventory counting:
Auditors not present at client’s inventory count:
Inventories located off the client’s premises:

21. Special Notes: Physical Inventory Observation
Auditors not present at client’s inventory count:

22. Physical Inventory Observation: Completeness
Tagging inventory
If tags are not used
Enquire as to inventory in other locations.

23. Physical Inventory Observation: Accuracy
Recount client’s counts
What should be in the auditor’s sample?
Should also trace inventory in both directions.
Perpetual inventory master file
Record client counts test-counted for subsequent testing.

24. Physical Inventory Observation: Classification
Examine inventory tags:
What to look for?
How about percentage of completion for work-in-process?

25. Physical Inventory Observation: Cutoff
Record for subsequent follow-up
Inventory for that shipment
Review shipping area for inventory
The receiving process

26. Physical Inventory Observation: Valuation
What is the auditor looking for?
What else should the auditor do?

27. Physical Inventory Observation: Rights and Obligations
Ownership of inventory is the prime focus in this instance
About what type of item is the auditor concerned?

28. Tests for Compilation and Detail tie-in
What about accounting principles?
What does compilation mean?
What items should be used in this test?
What else should be done?
Detail tie-in?

29. Tests for Existence What items should be used for this test?
What type of test is performed?

30. Tests for Completeness
What about unused tags?
How about the tags sequence?
Hand-held computers
Allows the user to scan inventory products
After the inventory count,
When the inventory count is synced with the system,

31. Tests for Accuracy
Want to ensure that the counts are accurate. What type of test?
Perform pricing tests. Type of tests?
Manufacturing
Non-Manufacturing

32. Tests for Classification
Want to inventory is classified correctly as to the type of inventory

33. Tests of Valuation
Remember the physical inventory observation. What was performed in this regard?
Perform test of lower of cost or market, selling price, and obsolescence

34. Tests for Rights and Obligations
The auditor is concerned about what type of inventory?
What type of test?
Consigned –in:
Consigned –out:

35. Tests for Presentation and Disclosure
What document should be examined here?
The financial statements

36. Interrelationship of Various Audit Tests
Beginning inventory +
Acquisitions of raw materials -
Ending inventory =
Raw material used
Tests of acquisition and payments cycle
Tests of cost accounting: Perpetual inventory records
Unit cost records
Raw materials
Work in process
Direct labour
Indirect labour and other manufacturing overhead
Cost of goods manufactured
Tests of physical inventory observation
Compilation and pricing
Cost of goods sold
Finished goods
Tests of payroll and personnel cycle
Tests of sales and collection cycle

37. Problem EP 12-10, Page 679
Consider the following examples of inventories in various businesses:
Pharmaceuticals in a drug company.
Fine chemical compounds in a biotechnical company.
Software in an information technology development company.
New condominium office units in a commercial real estate developer.
Fine art works in an interior design business.
Required:
For each item, indicate the challenges auditor's would face in trying to count and measure the inventory, and suggest an approach to obtain sufficient appropriate audit evidence.

38. Problem EP 12-11, Page 679 20X5 20X6 Sales of clothing $10,000,000
Li was assigned to work on the audit of A1 Clothing Ltd. Because she has been auditing similar companies for three years and is considered to be knowledgeable about the clothing retailing industry in Canada. Her employer, Bing Pas audited A! in 20X5 for the first time and had difficulty verifying the opening inventory number. This year, in 20X6, Li has the audited ending balance from 20X5, so she does not expect any problems with the inventory account. However, while doing the preliminary work for the audit, she calculated the gross profit margin and was surprised by her findings. Li thinks the gross margin indicates the ending inventory for 20X54 may be incorrect.
20X5
20X6
Sales of clothing
$10,000,000
$9,000,000
Cost of goods sold
7,000,000
5,500,000
Inventory
1,800,000
6,200,000
Required:
Explain whether you agree with Li. Support your answer with at least three points.
(Adapted from External Auditing AU1, June 2011, with permission of Chartered Professional Accountants of Canada, Toronto, Canada.)

39. Problem EP 12-14, Page 681
During his examination of the inventories and related accounts of Consumer Electronics Inc., a manufacturer and distributor of small appliances, and auditor encountered the following:
Several trucks loaded with finished goods were parked at the shipping dock. The contents of the trucks were excluded from the physical inventory.
The finished goods inventory included high volumes of several products, and many of their cartons were old and covered with dust. In response to the auditor’s questions, the plant manager stated that there was no problem as “all of these goods will eventually be sold, although some price incentives may be necessary.”
While reviewing the complex calculations used to develop the unit production costs of items in finished goods, the auditor noted that the costs of the company’s electrical engineering department had been treated as period expenses in previous years but were included in manufacturing overhead in the current year.
The company installed a new perpetual inventory system during the year. The auditor noted that many of the company’s year-end quantities differed from the actual physical inventory counts. Partly because of these problems, the company took a complete physical inventory at year-end.
Required:
Describe the additional audit procedures (if any) that the auditors should perform to obtain sufficient appropriate audit evidence in each of the preceding situations.
(Adapted from External Auditing AU1, June 2011, with permission of Chartered Professional Accountants of Canada, Toronto, Canada.)

40. Basic inventory auditing procedure
Problem DC 12-8, Page 685
You are conducting an audit of the financial statements of a wholesale cosmetics distributor with an inventory consisting of thousands of individual items. The distributor keeps its inventory in its own distribution centre and in two public warehouses. A perpetual inventory database is maintained on a computer system and updated at the end of each business day. Each individual inventory record of the perpetual inventory database contains the following data:
Item number
Location of item
Description of item
Quantity on hand
Cost per item
Date of last purchase
Date of last sale
Quantity sold during the year
You are planning to observe the distributor’s physical count of inventories as of a given date. You will have available a computer file, provided by the auditee, of the above items taken from their database as of the date of the physical count.
Your firm has a generalized audit software package that can upload and analyze the auditee’s computer data files.
Required:
List the basic inventory auditing procedures and, for each, describe how the use of the general purpose audit software package and the perpetual inventory database might be helpful to the auditor in performing such auditing procedures
Organize your answer as follows:
Basic inventory auditing procedure
How general purpose audit software and the inventory file data might be helpful