2. 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

3. 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

4. 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.

5. 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

6. 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

7. 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

8. 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

9. 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

10. Functions related to inventories
Purchasing
Receiving
Storing
Issuing
Processing
Shipping

11. 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

12. 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

13. 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

14. 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

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

16. 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

17. 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

18. Relating Controls to Assertions

19. 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.

20. 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.

21. 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.

22. Figure 12.1 Objectives of Major Substantive Procedures for Inventories and Cost of Goods Sold5 6

23. 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.

25. Relating Controls to Assertions

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

33. 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.

34. 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