1. Auditing the Inventory Management Process
Chapter Thirteen
Auditing the Inventory Management Process

2. Overview of the Inventory Management Process
Purchasing process
Revenue process
Purchase of raw materials
Human resource management process
Sale of goods
Payment of manufacturing overhead
Assignment of direct and indirect labor costs

3. Type of Documents and Records
Production Schedule – Based on the expected demand for the entity’s products.
Receiving Report – Records the receipt of goods from vendors.
Materials Requisition – Used to track materials during the production process.
Inventory Master File – Contains all the important information related to the entity’s inventory, including the perpetual inventory records.
Production Schedule

4. Type of Documents and Records
Production Data Information – Contains information about the transfer of goods and related cost accumulation at each stage of production.
Cost Accumulation and Variance Report – Material, labor, and overhead costs are charged to inventory as part of the manufacturing process. The variance report compares actual costs to standard or budgeted costs.
Inventory Status Report – Shows the type and amount of products on hand.
Shipping Order – Used to remove goods from the perpetual inventory records.
Shipping Order

5. The Major Functions

6. Key Segregation of Duties
Segregation of duties is a particularly important control in the inventory management process because of the potential for theft and fraud.

7. Key Segregation of Duties

8. Inherent Risk Assessment
The auditor should consider industry-related factors and operating and engagement characteristics when assessing the possibility of a material misstatement.
If industry competition is intense, there may be problems with the proper valuation of inventory. Technology changes in certain industries may also promote material misstatement due to obsolescence.
Products that are small and of high value are more susceptible to theft. The auditor must be alert to related-party transactions for acquiring raw materials and selling finished products. Prior-year misstatements are good indicators of potential misstatements in the current year.

9. Control Risk Assessment
Major steps in setting the control risk in the inventory management process.
Understanding and documenting the inventory management process based on a reliance strategy.
Planning and performing tests of controls on inventory transactions.
Setting and documenting the control risk for the inventory management process.

10. Control Procedures and Tests of Controls – Inventory Transactions

11. Control Procedures and Tests of Controls – Inventory Transactions
Occurrence of Inventory Transactions
The auditor’s main concern is that all recorded inventory exists. The auditor should also be concerned that goods may be stolen. Review and observation are the main tests of controls used by the auditor to test the control procedures.

12. Control Procedures and Tests of Controls – Inventory Transactions
Completeness of Inventory Transactions
The primary control procedure for completeness relates to recording inventory that has been received. Controls are closely related to the purchasing process.

13. Control Procedures and Tests of Controls – Inventory Transactions
Authorization of Inventory Transactions
The auditor’s concern with authorization in the inventory system is with unauthorized purchase or production activity that may lead to excess levels of certain types of finished goods.

14. Control Procedures and Tests of Controls – Inventory Transactions
Accuracy of Inventory Transactions
Inventory transactions that are not properly recorded result in misstatements that directly affect the amounts reported in the financial statements. Inventory purchases must be recorded at the correct price and actual quantity received. Inventory shipped must be properly recorded in cost of goods sold and the related revenue recognized.

15. Control Procedures and Tests of Controls – Inventory Transactions
Classification of Inventory Transactions
The client must have control procedures to ensure that inventory is properly classified as raw materials, work in process, or finished goods. By knowing which manufacturing department holds the inventory, the auditor is able to classify it by type.

16. Relating the Assessed Level of Control Risk to Substantive Procedures

17. Relating the Assessed Level of Control Risk to Substantive Procedures

18. Relating the Assessed Level of Control Risk to Substantive Procedures

19. Substantive Analytical Procedures
Auditing Inventory
Substantive Analytical Procedures

20. Auditing Standard Costs
Auditing Inventory
Auditing Standard Costs
Material Test the quantity and type of materials included in the product and the price of the materials.
Labor Gather evidence about the type and amount of labor needed for production and the labor rate.
Overhead Review the client’s method of overhead allocation for reasonableness, compliance with GAAP, and consistency.

21. Observing Physical Inventory
Auditing Inventory
Observing Physical Inventory
During the observation of the physical inventory count, the auditor should do the following:
Ensure that no production is scheduled. If production is scheduled proper controls must be established for movement between departments in order to prevent double counting.
Ensure that there is no movement of goods during the inventory count.
Make sure that the client’s count teams are following the inventory count instructions.
Ensure that inventory tags are issued sequentially to individual departments.

22. Observing Physical Inventory
Auditing Inventory
Observing Physical Inventory
Perform test counts and record a sample of counts in the working papers.
Obtain tag control information for testing the client’s inventory compilation.
Obtain cutoff information, including the number of the last shipping and receiving documents issued.
Observe the condition of the inventory for items that may be obsolete, slow moving, or carried in excess quantities.
Inquire about goods held on consignment for others or held on a “bill-and-hold” basis.

23. Tests of Details of Transactions, Account Balances, and Disclosure

24. Tests of Details of Transactions, Account Balances, and Disclosure

25. Tests of Details of Transactions, Account Balances, and Disclosure

26. Tests of Details of Transactions, Account Balances, and Disclosure
Possible causes of book-to-physical differences:
Inventory cutoff errors.
Unreported scrap or spoilage.
Pilferage or theft.

27. Tests of Details of Transactions, Account Balances, and Disclosure
Examples of Disclosure Items:
Cost method (FIFO, LIFO, retail method).
Components of inventory.
Long-term purchase contracts.
Consigned inventory.
Purchases from related parties.
LIFO liquidations.
Pledged or assigned inventory.
Disclosure of unusual losses from write-downs.
Warranty obligations.

28. Evaluating the Audit Findings - Inventory
At the conclusion of testing, the auditor should aggregate all identified misstatements. The likely misstatement is compared to the tolerable misstatement allocated to the inventory account.
Likely misstatement < Tolerable misstatement The auditor may accept the inventory account as fairly presented.
Likely misstatement > Tolerable misstatement The auditor may conclude the inventory is not fairly presented.

29. End of Chapter 13