Chapter 13 Auditing the Inventory

Management Process

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Overview of the Inventory

Management Process

Purchasing

process

Inventory

management

process

Revenue

process

• Purchase of

raw materials

• Payment of

manufacturing

overhead

Human resource

management

process

• Assignment of

direct and indirect

labor costs

• Sale of

goods

LO# 1

13-2

Types of Documents and Records

1. Production Schedule

2. Receiving Report

3. Materials Requisition

4. Inventory Master File

5. Production Data Information

6. Cost Accumulation and Variance Report

7. Inventory Status Report

8. Shipping Order

Production

Schedule

LO# 2

Inventory

Master

File

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The Major Functions

Inventory management

Authorization of production activity and maintenance of

inventory at appropriate levels; issuance of purchase

requisitions to the purchasing department.

Raw materials storesCustody of raw materials and issuance of raw materials to

manufacturing departments.

Manufacturing Production of goods.

Finished goods storesCustody of finished goods and issuance of goods to the

shipping department.

Cost accountingMaintenance of the costs of manufacturing and inventory in

cost records.

General ledgerProper accumulation, classification, and summarization of

inventory and related costs in the general ledger.

Functions in the Inventory Management Process

LO# 3

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Key Segregation of Duties

Segregation of Duties Possible Errors or Fraud

The inventory management function

should be segregated from the cost-

accounting function.

If the individual responsible for inventory management

also has access to the cost-accounting records,

production and inventory costs can be manipulated.

This may lead to an over- or understatement of

inventory and net income.

The inventory stores function should

be segregated from the cost-

accounting function.

If one individual is responsible for both controlling and

accounting for inventory, unauthorized shipments can

be made or theft of goods can be covered up.

The cost-accounting function should

be segregated from the general

ledger function.

If one individual is responsible for the inventory

records and also for the general ledger, it is possible for

that individual to conceal unauthorized shipments. This

can result in the theft of goods, leading to an

overstatement of inventory.

The responsibility for supervising

physical inventory should be

separated from the inventory

management and inventory stores

functions.

If the individual responsible for production

management or inventory stores functions is also

responsible for the physical inventory, it is possible that

inventory records to the physical inventory, resulting in

an overstatement of inventory.

LO# 4

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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.

LO# 5

13-6

Control Risk Assessment

Major steps in setting the control risk in the

inventory management process.

Understand and document the inventory

management process based on a reliance strategy.

Set and document the control risk for the inventory

management process.

Plan and perform tests of controls on inventory

transactions.

LO# 6

13-7

Control Activities and Tests of

Controls – Inventory Transactions

LO# 7

Assertion Test of Controls

Occurrence

Observe and evaluate proper segregation of duties. Review and test procedures for transfer

of inventory. Review and test procedures for issuing materials to manufacturing

departments. Review and test client procedures for account for numerical sequence of

materials requisitions. Observe the physical safeguards over inventory.

Completeness Review and test client's procedures for consignment goods.

AuthorizationReview authorized production schedules. Review and test procedures for developing

inventory levels and procedures used to control them.

Accuracy

Review and test procedures for taking physical inventory. Review and test procedures used

to develop standard costs. Review and test cost accumulation and variance reports. Review

and test procedures for identifying obsolete, slow-moving, and excess quantities. Review

the reconciliation of perpetual inventory to general ledger control account.

Cutoff

Review and test procedures for processing inventory included on receiving reports into the

perpetual records. Review and test procedures for removing inventory from perpetual

records based on shipments of goods.

Classification Review the procedures and forms used to classify inventory.

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Auditing Inventory

Assertions about Classes of Transactions and Events:Occurrence. Inventory transactions and events are valid.

Completeness . All inventory transactions and events have been

recorded.

Authorization. All inventory transactions and events are properly

authorized.

Accuracy. Inventory transactions have been properly computed and

recorded.

Cutoff. Inventory receipts and shipments are recorded in the correct

accounting period.

Classification. Inventory is recorded in the proper accounts.

LO# 8

13-9

Assertions about Account Balances at the Period End:

Existence. Inventory recorded on the books and records

actually exists.

Rights and obligations. The entity has the legal right to the

recorded inventory.

Completeness. All inventory is recorded.

Valuation and allocation. Inventory is properly recorded in

accordance with GAAP (e.g., lower of cost or market).

LO# 8

Auditing Inventory

13-10

Assertions about Presentation and Disclosure:Occurrence and rights and obligations. All disclosed events,

transactions, and other matters relating to inventory have occurred and pertain

to the entity.

Completeness. All disclosures relating to inventory that should have been

included in the financial statements have been included.

Classification and understandability. Financial information relating to

inventory is appropriately presented and described, and disclosures are clearly

expressed.

Accuracy and valuation. Financial and other information relating to

inventory are disclosed fairly and in appropriate amounts.

LO# 8

Auditing Inventory

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Substantive Analytical

Procedures

Substantive Analytical Procedure Possible Misstatement Detected

Compare raw material, finished goods, and total inventory

turnover to previous years' and industry averages.Obsolete, slow-moving, or excess inventory

Compare days outstanding in inventory to previous years'

and industry average.Obsolete, slow-moving, or excess inventory

Compare gross profit percentage by product line with

previous years' and industry data.Unrecorded or fictitious inventory

Compare actual cost of goods sold to budgeted amounts. Over- or understated inventory

Compare current-year standard costs with prior years' after

considering current conditions.Over- or understated inventory

Compare actual manufacturing overhead costs with

budgeted or standard overhead costs.Inclusion or exclusion of overhead costs

LO# 9

13-12

Auditing Standard Costs

Materials

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.

LO# 10

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Observing Physical Inventory During the observation of the physical inventory

count, the auditor should do the following:

1. Ensure that no production is scheduled.

2. Ensure that there is no movement of goods during the count.

3. Make sure that the client’s count teams are following instructions.

4. Ensure that inventory tags are issued sequentially to individual

departments.

5. Perform test counts.

6. Obtain tag control information.

7. Obtain cutoff information.

8. Observe the condition of the inventory – excess, obsolete, slow

moving.

9. Inquire about goods held on consignment.

LO# 11

13-14

Tests of Details of Transactions,

Account Balances, and Disclosures

Occurrence

Completeness

Authorization

Accuracy

Cutoff

Classification

Substantive Tests

of Transactions

LO# 12

Existence

Rights and obligations

Completeness

Valuation and allocation

Test of Details of

Account Balances

Accuracy and Valuation

Test of Details of

DisclosuresOccurrence, Rights and Obligations

Completeness

Classification and Understandability

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Tests of Details of Transactions,

Account Balances, and Disclosures Examples of Disclosure Items:

1. Cost method (FIFO, LIFO, retail method).

2. Components of inventory.

3. Long-term purchase contracts.

4. Consigned inventory.

5. Purchases from related parties.

6. LIFO liquidations.

7. Pledged or assigned inventory.

8. Disclosure of unusual losses from write-downs

or losses on long-term purchase commitments.

9. Warranty obligations.

LO# 12

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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 must conclude the inventory is not fairly presented.

LO# 13

13-17

End of Chapter 13

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