Business function and related

documents and records in the

inventory and warehousing cycle.
 BUSINESS FUNCTIONS IN THE CYCLE AND RELATED
DOCUMENTS AND RECORDS
The inventory and warehousing cycle is unique because of its close
relationship to other transaction cycles such as sales and purchasing
cycle.
Auditing this cycle is often the most complex and time-consuming
part of the audit for these reasons:
• Inventory is often the largest account on the balance sheet.
• Inventory is often in different locations, making physical control and counting
difficult.
• Diverse inventory items such as jewels, chemicals, and electronic parts are
often difficult for auditors to observe and value.
• Valuation is also difficult when estimation of inventory obsolescence is
necessary and when manufacturing costs must be allocated to inventory.
• There are several acceptable inventory valuation methods.
 BUSINESS FUNCTIONS IN THE CYCLE AND
RELATED DOCUMENTS AND RECORDS
Six functions make up the inventory and warehousing cycle:
1. Process purchase orders
2. Receive raw materials
3. Store raw materials
4. Process the goods
5. Store finished goods
6. Ship finished goods
 PERPETUAL INVENTORY MASTER FILE

Perpetual Inventory Master File

• Update continuously as raw material moved from storeroom to
production or as we buy material
• Includes information about the units of inventory acquired,
sold, and on hand, and often includes information about unit
cost
• Separate perpetual records are likely to be kept for raw
materials, work-in-process, and finished goods.
 Functions
Process Process the Store the Ship the
Receive raw Store raw
Purchase goods finished finished
material material
order goods goods

Receive raw Put raw

Put material Put material Ship to
Flow of material material in
into production into production customer
inventory storage

1. Shippin
1. Finished g doc.
1. Raw material good 2. FG
1. Raw requisition perpetual perpetu
1. Purchase 1. Receiving material form inventory al
Related requisition report inventory 2. Cost master file inventor
documentat 2. Purchase 2. Vendor perpetual accounting 2. Cost y
ion order invoice master file record accounting 3. Cost
record accounti
ng
Five parts of the audit of the inventory
and warehousing cycle.
 PARTS OF THE AUDIT OF INVENTORY
The audit of the inventory and warehousing cycle can be
divided into five activities within the cycle:
Acquire and record raw material
labor, and overhead Acquisition and payment cycle

Inventory and Warehousing

Transfer assets and costs Cycle

Ship goods and record

Sales and collection
revenue and costs

Inventory and Warehousing

Physically observe inventory Cycle

Inventory and Warehousing

Price and compile inventory Cycle
Perform audit tests of
cost accounting.
 AUDIT OF COST ACCOUNTING

Internally transfer assets and cost

Cost Accounting Controls:
process affecting physical inventory and tracking of related
cost from the time raw material are requisitioned to the
completion of manufactured product and its transfer to
storage.
There are two broad categories of controls:
1. Physical controls over raw materials, work-in-process, and
finished goods inventory
2. Controls over the related costs
Perpetual inventory master files maintained by persons who do not
have custody of or access to assets are a useful control
 AUDIT OF COST ACCOUNTING (CONT.)

Tests of Cost Accounting: The auditor is concerned with four

aspects of cost accounting:
1. Physical controls over inventory
2. Documents and records for transferring inventory
3. Perpetual inventory master files
4. Unit cost records
Audit of cost accounting: Physical controls over inventory (1 of
4)
What should be done?
Physically segregate and restrict access to storage areas for raw material, work-in-
process, and finished goods to control the movement of inventory.
Approved and prenumbered documents must be used for authorizing movement of
inventory to protect the assets from improper use.
Electronic or paper copies of these documents should be sent directly to accounting by
the persons issuing them, bypassing people with custodial responsibilities.
What auditor would do?
Auditor examine raw material storage area
Ask custodian to explain their duties related to the oversight and monitoring of
inventory.
If poor, more work/time is needed for the physical count
 Audit of cost accounting: Documents and records for
transferring inventory (2 of 4)
Auditor’s primary concern:
Verify the transfer of inventory from one location to another, all transfers
recorded, all transfer exist, quantity and description are accurate. Bar
code plays a major role if present.
Understand I/C before performing TOC and TOT.
Example:
Review sequence of raw material requisition, examine proper approval;
compare quantity, description and date with what is recorded in raw
material perpetual inventory master file
Compare completed production records with perpetual inventory master
file to make sure all finished goods are transferred to ending inventory
 Audit of cost accounting: Perpetual inventory master files
(3 of 4)

Reliability of perpetual inventory effect timing and extend of the

audit.
If good, count can de done before year end and CR is set to low.
Auditor examine documentation to support addition and
deduction in raw material, WIP and finished goods.
Remember, for raw material and finished sold testing are done
during acquisition and sale cycle.
If perpetual inventory is computerized and integrated then the
auditor will test computer control to support reduction in control
risk
 Audit of cost accounting: Unit cost records

(4 of 4)
Accounting for DL, DM, MOH must be accurate for the fair presentation of raw
material, work in process and finished goods
Integrate cost accounting with production
Auditor must understand I/C which is part of acquisition, payroll/personnel and
sales.
Direct Material (DM): Trace unit cost and unit to addition recorded in raw perpetual
inventory system
Direct Labor (DL): Trace payroll summary directly to job order cost sheet
Manufacturing Overhead (MOH): Consider the reasonableness of allocation method
and whether it is consistently applied.
IF DL is used then it is easy as the auditor already completed the payroll cycle.
IF machine hours is used then audit must examine the client record of machine
hours
 Substantive analytical procedures to
the accounts in the inventory and
warehousing cycle.
 SUBSTANTIVE ANALYTICAL PROCEDURES
Analytical procedures is the study of relationship/data between
various figures. Ratios, horizontal analysis, vertical analysis so
on.
Looking for unusual fluctuations or relationship for further
investigation. Review Common one
Analytical procedures are performed at three stages of audit:
1. Beginning of the audit (risk assessment procedures)
2. During (optional as a substantive step) Use judgement.
Extend depends on stability of numbers
3. End of audit (financial Analytical procedures)
 How to perform physical
observation audit tests for inventory.
 PHYSICAL OBSERVATION OF INVENTORY
Auditors have been required to perform physical observation tests of inventory since a major
fraud involving recording of nonexistent inventory in 1938 by McKesson & Robbins scandal.
Start by touring of the client’s inventory facilities (accompany by supervisor?), including
receiving, storage, production, planning, and record-keeping areas to gain understanding.
…then Assess the client business risk of material misstatement.
Examples of common sources of business risk for inventory include short product cycles,
potential obsolescence, use of just-in-time inventory, reliance on a few key suppliers, and use
of sophisticated inventory management technology.
…After assessing client business risk, the auditor determines performance materiality and
assesses inherent risk for inventory, which is typically highly material for manufacturing,
wholesale, and retail companies. Why?
Auditors often assess a high inherent risk for companies with significant inventory,
depending on the circumstances.
Auditors often have a greater concern for misstatements when inventory is stored in
multiple locations, the costing method is complex, and the potential for inventory
obsolescence is great.
 PHYSICAL OBSERVATION OF INVENTORY
Auditing standards require auditors to satisfy themselves about the effectiveness of the client’s methods of
counting inventory and the reliance they can place on the client’s representations about the quantities and
physical condition of the inventories. To meet the requirement, auditors must:
• Be present at the time the client counts its inventory.
• Observe the client’s counting procedures.
• Make inquiries of client personnel about their counting procedures.
• Make their own independent tests of the physical count.
Confusion?
An essential point in the auditing standards is the distinction between who observes the
physical inventory count and who is responsible for taking the count. The client is
responsible for setting up the procedures for taking an accurate physical inventory and
actually making and recording the counts. The auditor is responsible for evaluating and
observing the client’s procedures, including doing test counts of the inventory and
drawing conclusions about the adequacy of the physical inventory.
 PHYSICAL OBSERVATION OF INVENTORY
• What if inventory is housed in public warehouse?
• General speaking, no need physical examination is needed
• Auditors verify inventory by confirmation with the custodian.
• However, if inventory stored with outside custodians represents a significant portion of current
assets or total assets, the auditor should apply additional procedures:
❖Review the custodian’s inventory procedures
❖Obtain an independent accountant’s report on the custodian’s control procedures over the
custody of goods
❖Or observing the physical count of the goods held by the custodian, if practical.
 PHYSICAL OBSERVATION OF INVENTORY (CONT.)
Controls Over Physical Count: Regardless of inventory method, the client
must make a periodic physical count of inventory. The count may be done
at or near the balance sheet date or at an interim date.
Adequate controls over the client’s physical count of inventory include:
✓ proper client instructions for the physical count
✓supervision by responsible company personnel
✓independent internal verification of the counts by other client personnel
✓ independent reconciliations of the physical counts with perpetual
inventory master files
✓ adequate client control over count sheets or tags used to record
inventory counts.
if the client’s physical inventory count controls are inadequate, the auditor must spend more time making sure
that the physical count is accurate.
 PHYSICAL OBSERVATION OF INVENTORY
.

Audit Decisions: The auditor must make some decisions regarding

the observation of the physical inventory count:
1. Timing
2. Sample Size
3. Selection of Items
4. Physical Observation Tests
 PHYSICAL OBSERVATION OF INVENTORY: TIMING
.
• Timing—The auditor must decide whether the physical count can be
taken before year-end if auditor is satisfied that internal control over
perpetual inventory (addition and reduction) working effectively.
• Test transaction recorded in the perpetual inventory records from the
date of count.
• Compare perpetual inventory number on a sample basis
• IF I/C over perpetual inventory (or no perpetual onventory system)
then count at year.
 PHYSICAL OBSERVATION OF INVENTORY: SAMPLE
• The number of items to count is difficult because the auditor should
concentrate on observing the client’s procedures.
• Total number of hours spent not number of items in inventory.
• Number of hours is a factor of:
✓ Adequacy of internal control
✓ Dollar amount
✓ Type of inventory
✓ Location of inventory
✓ Nature and extend of errors/misstatement found in the previous audit.
Proper planning is required. Observe while they are counting!
 PHYSICAL OBSERVATION OF INVENTORY:
SELECTION OF ITEMS

• Selection of Items—When auditors observe the client counting inventory,

they should be careful to:
• Observe the counting of the most significant items.
• Inquire about items that are likely obsolete or damaged.
• Discuss with management the reasons for excluding any material items.
 PHYSICAL OBSERVATION OF INVENTORY:
PHYSICAL OBSERVATION TESTS

Physical Observation Tests: Balance-related audit objectives for

inventory are similar to those for other cycles.
Let’s review common tests of details of balances audit procedures for
physical inventory observation.
Design and perform audit tests of
pricing and compilation for
inventory.
Acquire and record raw material
labor, and overhead Acquisition and payment cycle

Inventory and Warehousing

Transfer assets and costs Cycle

Ship goods and record

Sales and collection
revenue and costs

Inventory and Warehousing

Physically observe inventory Cycle

Inventory and Warehousing

Price and compile inventory Cycle
 AUDIT OF PRICING AND COMPILATION
Auditors must verify that the physical counts of inventory are correctly
priced and compiled.
• Inventory price tests include tests of the client’s unit prices to determine
whether they are correct.
Adequate control for unit cost is needed to make sure company is valuing
ending inventory properly:
Standard cost records that indicate variances in material, labor, and
overhead costs are helpful to evaluate the reasonableness of production
records.
Keep standard update for any changes ion production process
Management should also have someone independent of the department
responsible for determining the costs review them for reasonableness.
Is there a policy for reporting slow moving, obsolete, damages inventory?
Maybe by a knowledge EE who can update the perpetual inventory file
and discuss and changes with production engineers or/and management
 AUDIT OF PRICING AND COMPILATION
Auditors must verify that the physical counts of inventory are
correctly priced and compiled.
• Inventory compilation tests include testing the client’s
summarization of the inventory counts, recalculating price times
quantity, footing the inventory summary, and tracing the totals to
the general ledger.
• The most important internal control for accurate unit costs, extensions,
and footings is internal verification by a competent, independent person
who relies on adequate documents and records that were used for
taking the physical count.
 AUDIT OF PRICING AND COMPILATION (CONT.)
Valuation of Inventory (price test): The auditor has three primary
concerns:
1. The method must be in accordance with accounting standards.
2. The application of the method must be consistent from year to year.
3. Inventory cost versus market value (replacement cost or net
realizable value) must be considered.
 AUDIT OF PRICING AND COMPILATION
Pricing Purchased Inventory: This includes raw materials, purchased parts, and supplies.
LIFO, FIFO, WA. What cost to include? Storage freight, discount, insurance etc.
Make sure it is consistent from year to year.

Pricing Manufactured Inventory: In pricing work-in-process and finished goods, the

auditor must consider the cost of raw materials, direct labor, and manufacturing overhead.
More complex than purchased inventory.
Review engineering specification for labor and material
How many hours it takes to finish a unit?

Cost or Market: Auditors consider whether market value is lower than historical cost.
Examine vendor invoice subsequent to purchases.
WIP and finished must be also evaluated to realizable value. Best indication here is selling prices
EXAMPLE OR 2