1. Audit of the Inventory and Distribution Cycle

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
Accounts Payable
Purchasing
Prepare prenumbered Purchase Requisition
Purchase Requisition
Purchase details N

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

6. Receive new materials Blind copy of
Accounts Payable
Purchasing A
Count goods, match with Purchase Order, and prepare Receiving Report
Blind copy of
Purchase Order
Storage with goods
Filed until goods received along with invoice copy
Receiving Report
Goods

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

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
Approved Sales Order
Prepare Multi-Part
Bill of Lading. Update
Perpetual Inventory
Master File on shipment SO BL
Order Entry
Common Carrier
Customer N
Billing and A/R
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

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. Inventory Tests of Details of Balances
Set materiality.
Assess Audit Risk and Inherent Risk for Inventory and Warehousing
Assess Control Risk for the applicable cycles
Identify assertions where substantive testing is insufficient, and/or there is risk of material misstatement
Design and perform test of control for the applicable cycles. Assess control risk
Design and perform substantive tests of inventory.
The type of audit procedures?
What is the sample size?
Items to be selected?
Timing – when to do the procedures?

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

20. Physical Inventory Observation: Accuracy
Recount client’s counts
Should also trace inventory in both directions.
Perpetual inventory master file
Record client counts test-counted for subsequent testing.

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

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

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

24. 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?

25. 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?

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

27. Tests for Completeness
What about unused tags?
How about the tags sequence?
Hand-held computers

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

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

30. 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

31. Tests for Rights and Obligations
The auditor is concerned about what type of inventory?
What type of test?

32. Tests for Presentation and Disclosure
What document should be examined here?

33. 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

34. Problem 17-18, p. 552
The table below shows sales, cost of sales, and inventory data for Aladdin Products Supply Inc., a wholesale distributor of cleaning supplies. All amounts are in the thousands.
2012
2011
2010
2009
Sales
$23.2
$21.7
$19.6
$17.4
Cost of Sales
17.1
16.8
15.2
13.5
Beginning inventory
2.3
2.1
1.9
1.5
Ending inventory
2.9
REQUIRED:
Calculate the following ratios:
Gross margin as a percentage of sales
Inventory turnover
List several logical causes of the changes in the two ratios.
Assume that $500,000 is considered material for audit planning purposes for Could any of the fluctuations in the computed ratios indicate a possible material misstatement? Demonstrate this by performing a sensitivity analysis.
What should the auditor do to determine the actual cause of the changes?

35. Problem 17-16, p. 551
Items 1 through 8 are selected questions typically found in questionnaires used by auditors to obtain an understanding of internal controls in the inventory and distribution cycle. In using the questionnaires for a particular client, a ‘yes’ response to a question indicates a possible internal control, whereas a ‘no’ response indicates a potential weakness.
Does the receiving department prepare prenumbered receiving reports and account for the numbers periodically for all inventory received, showing the description and quantity of materials?
Is all inventory stored under the control of a custodian in areas where access is limited?
Are all shipments to customers authorized by prenumbered shipping documents?
Is a detailed perpetual inventory master file maintained for raw materials inventory?
Are physical inventory counts made by someone other than storekeepers and those responsible for maintaining the perpetual inventory master file?
Are standard cost records used for raw materials, direct labour, and manufacturing overhead?
Is there a stated policy with specific criteria for writing off obsolete or slow moving inventory?
Is the clerical accuracy of the final inventory compilation checked by a person independent of those responsible for preparing it?
REQUIRED:
For each of the preceding questions, state the purpose of the internal control.
For each internal control, list a test of controls to test its effectiveness.
For each of the preceding questions, identify the nature of the potential financial misstatement(s) if the control is not in effect.
For each of the potential misstatements in part (c), list a substantive audit procedure to determine whether a material misstatement exists.

36. Problem 19-22, p. 664 Canadian 11th. Edition
You are testing the summarization and cost of raw materials and purchased part inventories as part of the audit of Rubber Products and Supply Corp. There are 2,000 inventory items with a total recorded value of $648,500.
Your audit will compare recorded descriptions and counts with the final inventory listing, compare unit costs with vendors’ invoices, and extend unit costs times quantity. A misstatement in any of those is defined as a difference. You plan to use monetary unit sampling.
You make the following decisions about the audit of inventory:
Tolerable misstatement (same as for upper as for lower)
$24,000
Average percent of error assumption - overstatements
50%
Average percent of error assumption - understatements
100%
Acceptable risk of incorrect acceptance 5%
Estimated error rate in the population
0.5%

37. Are the book values misstated?
REQUIRED:
What are the advantages of using monetary unit sampling in this situation?
What is the sample size necessary to achieve your audit objectives using monetary unit sampling?
Disregarding your answer to part (b), assume that a sample of 125 items is selected and that the following differences between book and audited values are identified (understatements are in parentheses). The book or recorded amounts are also shown.
Item No.
Difference
Book Amount 1
$19
$700 2 11
136 3
(19)
820 4 40
250 5 90
300 6 38
210 7
(90)
2,150 8 70 9
(85)
950
Total
$74
For each of the other 116 items in the sample, there was no difference between book and audited values.
Based on this sample, calculate the adjusted overstatement and understatement error bounds.
Are the book values misstated?

38. c. Misstatements
Item
Recorded Accounts Receivable Amount
Audited Amount
Misstatement
Misstatement Divided by Recorded Amount 1.
$700
681
$19 2.
136
125 11 3.
820
839
(19) 4.
250
210 40 5.
300 90 6.
2150 38 7.
2,150
2240
(90) 8.
230 70 9.
950
1035
(85)
Percentage Misstatement Bounds
Read along the row of 125 sample size on the first table (5% ARACR)
Number of Misstatements
Upper Precision Limit from Table 13-8
Increase in Precision Limit Resulting from Each Layer (Layers) 1 2 3 4 5 6

39. Determination of Initial Upper and Lower Misstatement Bounds
Overstatements
Number of Misstatements
Upper Precision Limit Portion
Recorded Value
Unit Misstatement Assumption
Misstatement Bound Portion (Columns
2 X 3 X 4) 1 2 3 4 5 6
Upper precision limit
Initial misstatement bound
Understatements
Number of Misstatements
Upper Precision Limit Portion
Recorded Value
Unit Misstatement Assumption
Misstatement Bound Portion (Columns
2 X 3 X 4) 1 2 3
Lower precision limit
Initial misstatement bound

40. Determination of Adjusted Misstatement Bounds
Number of Misstatements
Unit Misstatement Assumption
Sample Size
Recorded Population
Point Estimate
Bounds
Initial overstatement bound
Understatement misstatements 1 2 3
Sum
Adjusted overstatement bound
Number of Misstatements
Unit Misstatement Assumption
Sample Size
Recorded Population
Point Estimate
Bounds
Initial understatement bound
Overstatement misstatements 1 2 3 4 5 6
Sum
Adjusted understatement bound

41. Tolerable Exception Rate (TER)
Table 14-9
Estimated Population Exception Rate (EPER)
(in percentage)
Tolerable Exception Rate (TER) 2 3 4 5 6 7 8 9 10 15 20
5-Percent ARACR
0.00
149 99 74 59 49 42 36 32 29 19 14
0.25
236
157
117 93 78 66 58 51 46 30 22
0.50 .
0.75
208
1.00
156
1.25
124
1.50
192
103
1.75
227
153 88 77
2.00
181
127 68
2.25 61
2.50
150
109
2.75
173 95
3.00
195
129 84
3.25
148
112
3.50
167 76 40
3.75
185
100
4.00
146 89
5.00
158
116
6.00
179 50
7.00 37

42. 2 3 4 5 6 7 8 9 10 15 20 EPER 10–Percent ARACR TER . 0.00 114 76 57 4538 32 28 25 22 11
0.25
194
129 96 77 64 55 48 42 18
0.50
0.75
265
1.00 .
176
1.25
221
132
1.50
105
1.75
166 88
2.00
198 75
2.25 65
2.50
158
110 58
2.75
209 94 52
3.00
3.25
153
113 82
3.50 73
3.75
131 98
4.00
149
4.50
218
130 87 34
5.00
160
115 78
5.50
142
103
6.00
182
116
7.00
199
7.50
8.00 60
8.50 68
TER

43. ACTUAL NUMBER OF DEVIATIONS FOUND 1 2 3 4 5 6 7 8 9 10
Table 14-10
SAMPLE SIZE
ACTUAL NUMBER OF DEVIATIONS FOUND 1 2 3 4 5 6 7 8 9 10
5 PERCENT RISK OF OVER RELIANCE 25
11.3
17.6 . 30
9.5
14.9
19.5 35
8.2
12.9
16.9 40
7.2
18.3 45
6.4
10.1
13.3
16.3
19.2 50
5.8
9.1
12.1
14.8
17.4
19.9 55
5.3
8.3
11.0
13.5
15.9
18.1 60
4.9
7.7
12.4
14.6
16.7
18.8 65
4.5
7.1
9.4
11.5
15.5
19.3 70
4.2
6.6
8.7
10.7
12.6
14.4
16.2
18.0
19.7 75
3.9
6.2
10.0
11.8
15.2
18.4
20.0 80
3.7
11.1
12.7
14.3
15.8
17.3 90
3.3
5.2
6.8
8.4
9.9
14.1
16.8
100
3.0
4.7
7.6
8.9
10.2
14.0
16.4
125
2.4
6.1
9.3
10.3
12.2
13.2
150
2.0
3.1
4.1
5.1
6.0
6.9
8.6
200
1.5
2.3
3.8
6.5

44. 1 2 3 4 5 6 7 8 9 10 Sample size ACTUAL NUMBER OF DEVIATIONS FOUND .1 2 3 4 5 6 7 8 9 10
10 PERCENT RISK OF OVER RELIANCE 20
10.9
18.1 . 25
8.8
14.7
19.9 30
7.4
12.4
16.8 35
6.4
10.7
14.5 40
5.6
9.4
12.8
15.9
19.0 45
5.0
8.4
11.4
14.2
17.0
19.6 50
4.5
7.6
10.3
12.9
15.4
17.8 55
4.1
6.9
11.7
14.0
16.2
18.4 60
3.8
6.3
8.6
10.8
14.9
16.9
18.8 70
3.2
5.4
9.3
11.1
14.6
17.9
19.5 80
2.8
4.8
6.5
8.3
9.7
11.3
14.3
15.7
17.2
18.6 90
2.5
4.3
5.8
7.3
8.7
10.1
12.7
15.3
16.6
100
2.3
5.2
6.6
7.8
9.1
11.5
13.8
15.0
120
1.9
4.4
5.5
9.6
10.6
11.6
12.5
160
1.4
2.4
3.3
4.9
5.7
7.2
8.0
9.5
200
1.1
2.6
4.0
4.6
7.0